Will Lumber Liquidators (NYSE: LL) Repeat the Chinese Drywall Scandal?

NYSE: LL chartLumber Liquidators' (NYSE: LL) stock has been one of the hottest market topics for over a week now, thanks to a March 1 "60 Minutes" exposé on the company's products. Today the LL stock price closed up 10%, up from its previous 34% plunge. LL stock went from $51.81 to $38.70 after the "60 Minutes" report aired.

LL stock rose 5% this morning in pre-market trading after news broke that hedge fund manager Robert Chapman of Chapman Capital took a long position in the stock. He expressed confidence in the company and its prospects. At one point today, LL shares were up more than 14% before closing at $36.08.
CBS' segment claimed the Toano, Va.-based lumber company had been procuring its lumber from China, where there are no emissions standards tests. The result: the lumber sold by the company allegedly contained toxic levels of formaldehyde. At high levels, formaldehyde can cause cancer. At low levels, it can cause respiratory, nose, and throat issues.

Things looked bleak for LL and its stock earlier in the week.

Being accused of using dangerous materials from China does not always portend a company's demise. We learned this just a few years ago.

In fact, it's very likely you know someone who was affected by the Chinese drywall scandal, exposed in 2008...

The Last China Materials Scandal

Just after Hurricane Katrina and before the housing crisis, homes were constructed using drywall imported from China. But summer heat and humidity caused this drywall to emit sulfurous gasses carbon disulfide, carbonyl sulfide, and hydrogen sulfide. These gasses are carcinogenic.

This time it was CBS News exposing the company at fault - German-based Knauf Plasterboard Tianjin Co. Ltd.

CBS ran six random drywall tests across the nation and compared the results to the affected samples. While both samples released sulfuric gasses, the drywall from China released much more.

NYSE: LLTests were also performed by the Consumer Product Safety Commission after 3,500 complaints were filed from homeowners in 44 states.

Reports say the bulk of the defective drywall entered the country between 2005 and 2007. That's why U.S. home building was on a tear. The majority of affected homes were found in the Southeast - Florida and parts of Louisiana and Mississippi. These areas were hit the hardest by Hurricane Katrina.

On Feb. 8, 2013, almost four years after the tests were initially performed, News Orleans-district federal judge Eldon Fallon approved five class-action lawsuits against Knauf. The settlement called for home reparation and medical funds to be set up for victims. The settlements benefitted more than 10,000 property owners and were estimated to have been in excess of $1 billion, though the medical fund was capped at $30 million. Most of these funds were Knauf's responsibility to pay for in full.

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After the costly penalties, the corporation has not only recovered from the Chinese drywall fiasco, it's thriving. Knauf has always existed primarily in Europe, with two bases operating in the States. It's now dedicated to ecological causes that are more typically accepted in Europe, and has a polished, charitable image.

Now Lumber Liquidators faces similar future penalties - and founder and chairman Tom Sullivan is fighting back. Although his tactics could come back to hurt him and LL stock...

Lumber Liquidators' Rebuttal

Sullivan vehemently denied any wrongdoing on the company's part.

When "60 Minutes" had three separate certified labs run tests on the lumber, he countered the results, which found that each sample from LL was contaminated. Sullivan argued that the tests were invalid. He then stated that, contrary to the program's allegations, his company is not required by law to test finished products.

But damning news kept pouring in: "60 Minutes" also found that the lumber company's laminate flooring bore the label: "CARB-Phase 2 compliant." The sticker signified that the flooring had undergone California's Air Resource Board's inspection and passed. Obviously, it hadn't.

Last but not least, the broadcast featured workers from three Chinese mills who admitted to using core boards with higher levels of formaldehyde to save Lumber Liquidators up to 15% on price. Sullivan has said the workers featured were actors paid by the television show.

In a complaint filed with the U.S. Securities and Exchange Commission, Sullivan reiterated that his company has always been compliant with California's emissions standards. He then claimed the attacks on Lumber Liquidators were the work of short-sellers banding against him.

Short interest in the company's stock did reach 30% just before the "60 Minutes" segment aired - but it was widely known that the segment would air.

Another bit of fishy info: nonprofit Global Community Monitor is suing LL in a class action law suit. Global Community Monitor is backed by Wall Street short-selling investors. These investors joined in the fight themselves, claiming Lumber Liquidators ignored California's toxic warning statute.

But, again, Sullivan denies this. The employees featured in the broadcast were not identified, leaving reasonable doubt as to the validity of their statements. In Lumber Liquidators' SEC filing, it claims that "the suppliers have confirmed that all products provided to Lumber Liquidators have been and are CARB-compliant."

In a statement made to CNBC on March 11, Sullivan said "the real story" about his company is only starting to come out. Sullivan said the company will offer some customers free indoor air testing.

But if any problems show up in the testing, LL might not end up back on track like Knauf...

"Let's not be fooled, this is an uptick after a tremendous sell-off," Yahoo! Finance columnist Rick Newman wrote today of LL stock's rise. "It's been ugly for Lumber Liquidator shareholders. If they offer testing and everyone has a problem, this company is in deep doo-doo."

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